Taxation of Islamic Finance Discussion Paper

Review of the taxation tReatment of islamic finance

Discussion Paper

Board of taxationoctober 2010

boardtaxationthe ofwww.taxboard.gov.au

Commonwealth of Australia 2010 ISBN 978-0-642-74640-5

This work is copyright. Apart from any use as permitted under the Copyright Act 1968, no part may be reproduced by any process without prior written permission from the Commonwealth. Requests and inquiries concerning reproduction and rights should be addressed to:

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Or posted at: http://www.ag.gov.au/cca

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CONTENTS

FOREWORD ...................................................................................................................... VEXECUTIVE SUMMARY ...................................................................................................... VIICHAPTER 1: INTRODUCTION ............................................................................................. 1Terms of reference ........................................................................................................................ 1Review processes ......................................................................................................................... 2CHAPTER 2: ISLAMIC FINANCE .......................................................................................... 5Principles of Islamic finance .......................................................................................................... 6Islamic finance in Australia ............................................................................................................ 9CHAPTER 3: AUSTRALIAS FINANCE TAXATION FRAMEWORK ........................................... 11Overview ...................................................................................................................................... 11Taxation of financial arrangements (TOFA) ................................................................................ 13Debt/equity rules ......................................................................................................................... 13TOFA tax timing rules .................................................................................................................. 15Hire purchase and finance lease ................................................................................................. 17Non-resident withholding tax ....................................................................................................... 19Interaction between CGT rules and finance taxation & securities lending arrangements .............................................................................................................................. 21GST ............................................................................................................................................. 22State and Territory taxes ............................................................................................................. 23Observations on the current finance taxation landscape ............................................................ 26CHAPTER 4: ISSUES RAISED BY AUSTRALIAS CURRENT APPROACH TO FINANCE TAXATION ....................................................................................................................... 27Case Study One: Cost plus profit sale ........................................................................................ 27Case Study Two: Interbank finance ............................................................................................ 32Case Study Three: Finance lease and hire purchase ................................................................. 38Case Study Four: Purchase order ............................................................................................... 41Case Study Five: Pre-paid forward sale ...................................................................................... 44Case Study Six: Profit and loss sharing partnership ................................................................... 47Case Study Seven: Lease backed Islamic bond ......................................................................... 52Case Study Eight: Islamic risk sharing arrangements ................................................................ 60

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CHAPTER 5: INTERNATIONAL APPROACH ........................................................................ 63United Kingdom ........................................................................................................................... 63Ireland .......................................................................................................................................... 64South Korea ................................................................................................................................. 65France ......................................................................................................................................... 65Singapore .................................................................................................................................... 66Malaysia ...................................................................................................................................... 66Indonesia ..................................................................................................................................... 68APPENDIX A: SUMMARY OF QUESTIONS .......................................................................... 69APPENDIX B: SUMMARY OF TAX TREATMENT UNDER EXISTING TAX FRAMEWORKS ................................................................................................................ 73

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FOREWORD

The Board of Taxation (Board) has been asked by the Government to review the taxation treatment of Islamic finance products. This review arises from the report of the Australian Financial Centre Forum, Australia as a Financial Centre Building on our Strengths, which recommended that the Board of Taxation undertake such a review in order to ensure that Islamic finance products have parity with conventional products, having regard to their economic substance (Recommendation 3.6).

The purpose of this discussion paper is to facilitate the development of appropriate responses to remedy impediments in the law in a way that is consistent with the terms of reference for this review. To assist stakeholders the paper:

examines the current approach to finance taxation in Australia;

identifies issues associated with Australias current approach to the taxation of Islamic finance products; and

examines the tax policy response to the development of Islamic finance products in other jurisdictions (including the United Kingdom, France, South Korea and other relevant jurisdictions).

Consultation with industry and other affected stakeholders and submissions from the public will play an important role in shaping the Boards recommendations to the Government.

The Board has requested that submissions regarding this review be made by 17 December 2010 to enable the Board to finalise its report in the timeframe requested by the Government.

Annabelle Chaplain Chairman Working Group

Richard Warburton AO Chairman Board of Taxation

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EXECUTIVE SUMMARY

The Board has been asked to review the taxation treatment of Islamic finance products and to make recommendations (for Commonwealth tax laws) and findings (for State and Territory tax laws) that will ensure, wherever possible, that Islamic finance products have parity of tax treatment with conventional finance products.

Conventional banking and finance is based on interest bearing loans or investments, or equity financing arrangements. Islamic banking and finance provides equivalent functionality to conventional finance but the underlying arrangement is based on the trading of assets, profit and loss sharing investments or leasing arrangements.

The terms of reference ask that, if the Board concludes that amendments to the tax law are required, the Board should consider whether adjustments can be made to existing tax frameworks rather than the development of specific provisions directed solely at Islamic financial products. In this regard, the terms of reference recognise that there are various tax frameworks or regimes in the current law that specifically deal with financial products.

Chapter 1 provides an overview of the review process including the terms of reference for the review, consultations and guidelines for submissions.

Chapter 2 provides an overview of the principles of Islamic finance including the main types of Islamic finance products. It also considers the opportunities that Islamic finance may provide Australia.

Chapter 3 summarises the frameworks in the existing tax law for the taxation of financial products. The frameworks include income tax, interest withholding tax, goods and services tax and state taxes.

Chapter 4 looks at how those frameworks apply, and the issues raised by them, in the context of case studies that are consistent with the principles of Islamic finance. The issues include uncertainty in the application of the law, double taxation, tax treatment that does not appropriately recognise the financing component of arrangements and increased cost of certain Islamic finance products in comparison to conventional finance.

Chapter 5 examines the tax policy response to the development of Islamic finance products in other jurisdictions.

CHAPTER 1: INTRODUCTION

1.1 The then Assistant Treasurer and the Minister for Financial Services, Corporate Law and Superannuation announced on 26 April 2010, that the Board would undertake a comprehensive review of Australias tax laws to ensure that, wherever possible, they do not inhibit the expansion of Islamic finance, banking and insurance products.

1.2 In May 2010 the then Assistant Treasurer launched a book entitled Demystifying Islamic Finance Correcting Misconceptions, Advancing Value Propositions. At the launch the then Assistant Treasurer said:

We are taking a keen interest in ensuring there are no impediments to the development of Islamic finance in this country, to allow market forces to operate freely. This is in line with our commitment to foster an open and competitive financial system, and a socially inclusive environment for all Australians. We also recognise that Islamic finance has great potential for creating jobs and wealth.

TERMS OF REFERENCE

1.3 The then Assistant Treasurer announced the terms of reference for the review on 12 May 2010. Specifically, the Board is asked to:

identify impediments in current Australian tax laws (at the Commonwealth, State and Territory level) to the development and provision of Islamic finance products in Australia;

examine the tax policy response to the development of Islamic finance products in other jurisdictions (including the United Kingdom, France, South Korea and relevant Asian jurisdictions); and

make recommendations (for Commonwealth tax laws) and findings (for State and Territory tax laws) that will ensure, wherever possible, that Islamic finance products have parity of tax treatment with conventional finance products.

1.4 In conducting the review, the Board has been asked to have regard to the following principles as far as possible:

The tax treatment of Islamic finance products should be based on their economic substance rather than their form.

Chapter 1: Introduction

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Where an Islamic finance product is economically equivalent to a conventional finance product, the tax treatment of the two products should be the same.

If the Board concludes that amendments to the tax law are required, the Board should consider whether adjustments can be made to existing tax frameworks rather than the development of specific provisions directed solely at Islamic finance products.

1.5 The Board is asked to report to the Assistant Treasurer by June 2011.

The review team 1.6 The Board has appointed a Working Group of its members comprising Ms Annabelle Chaplain (Chairman), Mr Richard Warburton, Ms Elizabeth Jameson, Mr Keith James and Mr Curt Rendall to oversee its review of the taxation treatment of Islamic finance products. The Working Group is being assisted by an Expert Panel, members of the Boards Secretariat, and officers from the Treasury and the Australian Taxation Office are also assisting in its consideration of the issues. The Expert Panel comprises:

Mr Asad Ansari Director, Deloitte;

Mr Michael Barbour General Manager Tax, Westpac;

Mr Emmanuel Alfieris Head of Trade, Westpac;

Mr Hyder Gulam Associate, Logie-Smith Lanyon Lawyers;

Mr Zein El Hassan Partner, Clayton Utz;

Ms Kirsten Fish Partner, Clayton Utz;

Mr John Masters Director, ING Bank Australia; and

Mr Shahriar Mofakhami Consultant, Greenfields Financial Services Lawyers.

REVIEW PROCESSES

1.7 Consistent with the terms of reference for this review, if the Board concludes that amendments to the tax law are required, the Board will consider whether adjustments can be made to existing tax frameworks rather than the development of specific provisions directed solely at Islamic finance products. For this reason the scope of the Boards discussion paper is aimed at examining those frameworks and identifying the limitations of Australias current finance taxation law in delivering on the principles outlined in the terms of reference, particularly in the context of the type of arrangements commonly used in Islamic finance.


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Submissions 1.8 The Board is inviting written submissions to assist with its review. To assist those making submissions, the Board has prepared this discussion paper which:

examines the current approach to finance taxation in Australia;

identifies issues associated with Australias current approach to the taxation of Islamic finance products; and

provides an overview of the approach to the taxation of Islamic banking and finance in other jurisdictions.

1.9 Submissions should address the terms of reference set out in paragraph 1.3 and the issues and questions outlined in this discussion paper (a full list of questions is at Appendix A). It is not expected that each submission will necessarily address all of the issues and questions raised in the discussion paper. The closing date for submissions is 17 December 2010. Submissions can be sent by:

Mail to: The Board of Taxation C/- The Treasury Langton Crescent CANBERRA ACT 2600 Fax to: 02 6263 4471 Email to: [email protected]

1.10 Stakeholders making submissions should note that Board members and members of the Board's review team will have full access to all submissions to this review. All information (including name and contact details) contained in submissions may be made available to the public on the Board of Taxation website unless it is indicated that all or part of the submission is to remain in confidence. Automatically generated confidentiality statements in emails do not suffice for this purpose. Respondents who would like all or part of their submission to remain in confidence should provide this information marked as such in a separate attachment. A request for a submission to be made available under the Freedom of Information Act 1982 (Commonwealth) that is marked 'confidential' will be determined in accordance with that Act.

Consultation meetings 1.11 The consultation process will provide an opportunity to discuss the issues canvassed in more detail. The Board is planning consultation forums in Canberra, Sydney and Melbourne during the consultation period as a further mechanism for obtaining views and to assist stakeholders in preparing written submissions. Information regarding the consultation forums can be found on the Board of Taxation website, www.taxboard.gov.au or by calling the Boards Secretariat on 02 6263 4364.


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1.12 The Board also proposes to hold targeted consultation meetings with selected stakeholders who have made submissions. The purpose of these meetings will be to clarify aspects of these submissions and to explore possible responses to issues raised in the submissions.

CHAPTER 2: ISLAMIC FINANCE

2.1 Islamic finance is a growing market. The global market for Islamic financial services, as measured by Shariah compliant assets, is estimated to have reached $951 billion in 2008, a 25 per cent increase from $758 billion in 2007. Assets have grown from about $150 billion in the mid 1990s. Commercial banks account for the bulk of the assets with investment banks, sukuk1 issues, funds and insurance making up the balance.2

2.2 The Austrade publication titled Islamic Finance (2010) identifies that the growth of Islamic finance is being driven by the following factors:

Petrodollar liquidity: Foreign investment plays an important role for petrodollar investors, whose domestic economies and financial systems are too small to absorb all capital from oil export revenues. This presents significant opportunities for the Islamic banking and finance industry. Petrodollar liquidity is expected to remain high over the long term due to the finite supply of oil reserves;

Muslim population: Relatively rapid Muslim population growth worldwide and rising living standards will see increased demand for Islamic finance;

Low penetration levels: In spite of growth in the Islamic banking and finance industry, there remains a lack of depth across asset classes and products, signifying untapped potential. There is considerable scope for further development of Islamic banking and finance in countries such as Indonesia, India and Pakistan, which have the largest Muslim populations in the world; and

Ethical character and financial stability of Islamic financial products: Islamic financial products have an ethical focus (notably excluding investment in alcohol and gambling) and a risk profile that will also appeal to a wider ethical investor pool.

2.3 Currently, the Middle East and South East Asia are the primary locations for Islamic capital. In particular, Malaysia, Iran and the majority of countries from the Gulf

1 Sukuk is the Islamic finance equivalent of conventional tradable notes or bonds, which represents the ownership (actual or beneficial) by the sukuk holders in an underlying Shariah compliant asset or financing arrangement. Returns are paid to the investors in line with their proportional ownership in that asset and investment, and vary according to asset performance rather than the time elapsed.

2 International Financial Services London (IFSL) Research, Islamic Finance 2010, London, January 2010, p 1-2.

Chapter 2: Islamic finance

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Co-operation Council (GCC) such as Kuwait3 are seen as the main centres of Islamic finance, with significant activity also taking place in the United Kingdom and more recently in countries such as Turkey, Sudan, Egypt, Jordan and Syria and Asian countries such as Indonesia, Hong Kong, Singapore, Bangladesh, Pakistan and China.4

2.4 The Austrade publication identifies that some of the opportunities Islamic finance may provide Australia include:

attracting foreign Islamic banks and conventional banks with Islamic windows5 to establish operations in Australia;

attracting investment in Australian assets and businesses from overseas Shariah investors and tapping into new funding sources through sukuk and other securitised issues;

Australian based banks providing from Australia a range of Shariah compliant investment and financing products and services to Islamic banks, corporations, institutions and high net worth individuals in the Asia Pacific and the Gulf regions;

fund managers establishing Shariah compliant funds for Asian and Gulf institutional and high net worth individual investors;

local exchanges providing Islamic listings platforms for domestic and international issues of Shariah compliant instruments; and

Australian based financial firms, professional services providers and educational institutions exporting their services into Asia and the Gulf.

PRINCIPLES OF ISLAMIC FINANCE

2.5 The Islamic finance system is based on the principles of Shariah. The concept that the right to property should come from a persons own labour and the sanctity of contracts are core principles of Islamic finance. Risk sharing, prohibition of interest (a

3 DFAT country information: Kuwait has significant investment in Australia, at A$590 million in 2009, in real estate, hotels, banking and a liquid natural gas project. Kuwait Finance House, one of the largest Islamic banks in Kuwait, recently opened an office in Melbourne. Kuwait currently has plans to develop around $325 billion worth of infrastructure and development projects, representing significant opportunities for Australian companies.

4 International Financial Services London (IFSL) Research, Islamic Finance 2010, London, January 2010, p 2.

5 An Islamic window is a specialised arm within conventional financial institutions that offer Shariah compliant products for their clients.


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prohibition of pure debt security) and the elimination of contractual ambiguity and other forms of exploitation are some of the implications of these core principles.6

2.6 Standard and Poors have summarised the main features of an Islamic economic system as follows:7

Prohibition of paying and receiving interest Interest must not be charged or paid on any financial transaction.

Prohibition of uncertainty or speculation Uncertainty in contractual terms and conditions is forbidden. However, risk

taking is allowed when all the terms and conditions are clear and known to all parties.

Prohibition of financing certain economic sectors Financing of industries deemed unlawful by Shariah such as weapons, pork

and gambling is forbidden.

Principle of profit and loss sharing Parties to a financial transaction must share in the risks and rewards attached to

it.

Principle of asset backing Each financial transaction must refer to a tangible, identifiable underlying asset.

2.7 Islamic finance broadly describes banking and financial products or arrangements that comply with the principles of Shariah. Conventional banking and finance is based on interest bearing loans or investments, or equity financing arrangements. Islamic banking and finance provides equivalent functionality to conventional finance but the underlying arrangement is based on the trading of assets, profit and loss sharing investments or leasing arrangements.

2.8 Islamic banking, finance and insurance products are structured based on either one or a combination of Shariah compliant financing contracts or concepts. A summary of the main contracts follows.

6 Iqbal, Z & Mirakhor, A An Introduction to Islamic Finance: Theory and Practice (Wiley 2007) p 53. 7 Standard and Poors, Islamic Finance Outlook 2010, (2010) p 61.


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Murabahah (Cost plus profit sale) 2.9 Murabahah refers to the sale and purchase of an asset whereby the cost and profit margin are made known and agreed by all parties involved. The settlement for the purchase can be either on a cash basis, a deferred lump sum basis or on an instalment basis, which will be specified in the agreement.

Tawarruq (Cash finance sale) 2.10 This is a variation of murabahah. Under a tawarruq contract a person buys a commodity or some goods on credit with an understanding of paying back the price either in instalments or in full in the future. The commodity is immediately sold by the person to a third party to obtain cash.

Istisna (Purchase order) 2.11 Under an istisna contract a buyer will require a seller or a contractor to deliver or construct an asset that will be completed in the future according to the specifications given in the sale and purchase contract. Both parties to the contract will decide on the sale and purchase prices as they wish and the settlement can be delayed or arranged based on the schedule of work completed.

Salam (Forward sale) 2.12 Salam refers to a contract for the purchase of assets by one party from another party on immediate payment and deferred delivery.

Musharakah (Profit and loss sharing partnership) 2.13 Under a musharakah contract a partnership is established by means of an agreement or arrangement whereby two or more parties agree that each of them contributes to the capital of the partnership either in the form of cash or in kind and shares in its profit and loss. Any profit derived from the venture will be distributed based on a pre-agreed profit sharing ratio, but a loss will be shared on the basis of equity participation.

Musharakah Mutanaqisah (Diminishing partnership) 2.14 This is a musharakah contract in which one of the parties promises to purchase the equity share of the other party gradually until the title of the equity is completely transferred to them.

Mudarabah (Profit sharing partnership) 2.15 Under a mudarabah contract one party provides capital and the other party acts as an entrepreneur who solely manages the project. If the venture is profitable, the


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profit will be distributed based on a pre-agreed profit sharing ratio. In the event of a loss, the loss shall be borne solely by the provider of the capital unless it is due to the misconduct or negligence of the entrepreneur.

Ijarah (Operating lease) 2.16 Under an ijarah contract a lessor (owner) leases out an asset to its client at an agreed rental fee and pre-determined lease period. The lessor retains ownership of the leased asset.

Ijarah Muntahiah Bi Tamlik (Finance lease) 2.17 This is similar to the ijarah contract except that the lessor also makes a promise to transfer the ownership of the asset at the end of the lease period via a separate sale agreement or gift.

Sukuk (Islamic bond) 2.18 Sukuk is the Islamic finance equivalent of conventional tradable notes or bonds, which represents the ownership (actual or beneficial) by the sukuk holders in an underlying Shariah compliant asset or financing arrangement. Returns are paid to the investors in line with their proportional ownership in that asset and investment, and vary according to asset performance rather than the time elapsed.

Takaful (Insurance)

2.19 Under the takaful contract parties invest in a pooled investment vehicle where they joint-guarantee each other against specified events and profits are paid out to investors upon the occurrence of a specified event. The fund does not seek to make profits but to mitigate its losses. However, the fund may invest surplus funds in Shariah compliant assets or financing arrangements.

Wakalah (Agency) 2.20 Wakalah is a contract of agency which gives the power to a person to nominate another person to act on their behalf based on agreed terms and conditions.

ISLAMIC FINANCE IN AUSTRALIA

2.21 Australia has a Muslim population of about 365,000, that is, 1.7 per cent of the total population.8 There are a small number of Shariah compliant financial products and services currently available in Australia.

8 ABS 2006 Census.


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2.22 There is no fully-fledged Islamic bank or Islamic banking window currently operating in Australia. Westpac and National Australia Bank have both introduced Shariah compliant products to the market. In February 2010, Westpac launched a Special Interbank Placement for Islamic Financial Institutions. The offering is based on commodity inventories. It was launched in conjunction with the release of Austrade's Islamic Finance publication. National Australia Bank offers a no interest loan scheme for low income earners (in receipt of Centrelink payments). 9

2.23 In 2004, Victoria recognised that Islamic finance products should be placed on an equal footing with conventional finance products. One reform was the removal of double stamp duty charges on property purchases. Other changes included recognising the principle of profit sharing and allowing Islamic contracts to avoid certain terms which are not permitted, such as interest.10

2.24 A number of institutions have been established in Australia to meet the demand for Islamic finance products. The Muslim Community Cooperative Australia (MCCA), which is headquartered in Melbourne, provides Islamic mortgages. Two smaller firms, Sydney-based cooperative Islamic Cooperative Finance Australia (ICFA)11 and Iskan Finance12, also offer consumers a range of products to facilitate the purchase of homes and funds for education.13

2.25 Kuwait Finance House Australia is the first foreign Islamic bank to set up operations in Australia. Currently, its focus is developing wholesale Islamic financial services here but it does have experience in serving the retail market in other jurisdictions such as in Malaysia.

9 NAB offers No Interest Loans Schemes (NILS) which by design would be Shariah compliant. NILS is a community based micro-credit scheme. NILS are designed to offer people on low incomes the opportunity to access credit for a modest amount, usually between $800-$1,000 for an essential household item or service without any fees, charges or interest payments.

10 Victorian Government fact sheet Islamic Finance, Melbourne, Victoria, Australia April 2010. 11 Islamic Co-operative Finance Australia Limited, Auburn NSW Web: http://www.icfal.com.au/. 12 http://www.iskan.com.au/. 13 Cane, Elton Retail Delivery & Distribution Finance with faith (Foresight Publishing 7 May 2010).

CHAPTER 3: AUSTRALIAS FINANCE TAXATION FRAMEWORK

OVERVIEW

3.1 The terms of reference ask that, if the Board concludes that amendments to the tax law are required, the Board should consider whether adjustments can be made to existing tax frameworks rather than the development of specific provisions directed solely at Islamic finance products. In this regard, the terms of reference recognise that there are various tax frameworks or regimes in the current law that specifically deal with financial products. An issue for examination, therefore, is whether existing frameworks are appropriate for the taxation of Islamic finance products.

3.2 Accordingly, this chapter summarises the frameworks in the existing tax law for the taxation of financial products. Chapter 4 will look at how those frameworks apply and the issues raised by them, in the context of case studies that are consistent with the principles of Islamic finance.

3.3 The Australian finance taxation landscape is made up of substance, form and transaction based frameworks. For instance, various income tax frameworks introduced into the tax law as part of the taxation of financial arrangements reforms (TOFA) have been a response to the failure of general tax provisions to properly reflect the substance of financial products and the financial innovation that has been occurring. As a result, recent income tax reforms to finance taxation have been substance based. The capital gains tax (CGT) framework is a combination of form and substance based rules. The goods and services tax (GST) framework and state duty taxes are transaction based rules.

3.4 In terms of the general income tax provisions the general assessable income provision includes income when it is derived. Expenses incurred in deriving assessable income are deductible when incurred, provided that they are not of a private, domestic or capital nature. To a large degree income and expenses in relation to financial products are recognised for tax purposes when realised. Broadly speaking, the CGT provisions also operate on a realisation basis.

3.5 The traditional judicial approach has been to apply the general income tax provisions to financial products in accordance with their legal form. For example, under a finance lease, the lessor has been taxed on the full lease rentals while being able to deduct capital allowances as the owner of the relevant asset even where the

Chapter 3: Australias finance taxation framework

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economic ownership of the asset is held by the lessee. Alternatively, for financial accounting purposes, only the finance charge component of the rental payment is recognised as income of the lessor (without any separate recognition of an expense for depreciation in respect of the asset).

3.6 Another aspect of the tax law outside the specific tax frameworks relating to financial products is that often there is little or no regard to the time value of money. For instance, a CGT event involving the deferral of payment for a disposal of a CGT asset. The proceeds for the purpose of working out whether there is a gain or loss is the nominal amount of the payment, notwithstanding that in substance there is a provision of an asset for its market value at the time it is provided, plus the advance of credit from the vendor of that value until the time of payment.

3.7 Reforms to finance taxation have accordingly sought to better reflect the economic substance of the relevant arrangements and how, in a commercial sense, the arrangements are used and viewed. This chapter sets out the frameworks that have been adopted to give effect to this substance based objective.

3.8 There are special tax arrangements for the taxation of trusts and partnerships. Trust and partnership arrangements are currently excluded from the definition of a financing arrangement.

3.9 Partnerships are associations of general law partners or limited partners carrying on a business in common with a view to profit and also include for income tax purposes an association of persons in receipt of income jointly. A partnership is not a taxable entity unless it is a corporate limited partnership. Each partner is taxable on their share of the net income of the partnership. Apart from certain venture capital limited partnerships and foreign hybrid entities, limited partnerships (referred to as corporate limited partnerships) are taxed like companies for income tax purposes.

3.10 The GST regime applies to the value added on most goods and services consumed in Australia. It applies at a uniform rate of 10 per cent to the supply or importation of taxable goods and services, based on their value. Difficulties in identifying the value added at the transaction level for certain financial supplies means that most financial supplies are input taxed rather than taxable under the GST regime. Input taxation means that entities making financial supplies are not liable to GST on the financial supply and cannot claim input tax credits for the GST paid on related financial acquisitions. Generally financial supplies have the meaning given by the GST Regulations.

3.11 Certain asset financing arrangements are treated as taxable supplies (and not financial supplies) for instance hire purchase and leasing, including leases that are finance leasing arrangements under financial accounting standards. Under a hire purchase, the GST is payable upfront on the sale consideration. Under a lease (including a finance lease) the GST is payable over the term of the lease. Dealing in an interest in a partnership or trust is also a financial supply. A partnership for GST


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purposes has the same meaning as for income tax purposes and the partnership must register for GST if it meets the registration turnover threshold.

TAXATION OF FINANCIAL ARRANGEMENTS (TOFA)

3.12 The various income tax frameworks or regimes introduced into the tax law as part of the TOFA reform include the debt/equity rules, the foreign currency gains and losses rules and the tax timing and hedging rules. These rules, some of which are described below, give greater weight to economic substance than the ordinary income and deduction rules of the income tax law. This is designed to improve the efficiency of financial decision making and to lower compliance costs.

DEBT/EQUITY RULES

3.13 Financing arrangements can be either debt, equity or a combination of debt and equity. Broadly defined, a debt represents a right to have the money lent repaid with interest, while equity represents ownership of capital and typically a right to share in the profits. The debt/equity rules in Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997) draw the border between debt and equity in such a way that the legal form of an interest is generally not characterised in a way that is at odds with its economic substance.

3.14 Division 974 defines what constitutes an equity interest in a company and what constitutes a debt interest for tax purposes. The debt/equity distinction determines the tax treatment of a return on a financing interest issued by a company. The definition of debt interest also constitutes a key component of the thin capitalisation regime as it is used to determine whether an entity has an excessive amount of debt. It is also relevant for withholding tax purposes, that is, where the dividing line is between what returns may be subject to dividend withholding tax and what may be subject to interest withholding tax. The interest withholding exemptions draw on the definition of debt interest.

3.15 Under Division 974, the test for distinguishing debt interests from equity interests focuses on a single organising principle the effective obligation of an issuer to return to the investor an amount at least equal to the amount invested. If the term of the interest is ten years or less, the amount to be paid to the holder must equal or exceed the issue price in nominal value terms. If the term is greater than 10 years, the amount to be paid to the holder must equal or exceed the issue price in present value terms.

3.16 This test seeks to provide a more coherent, substance based test which is less reliant on the legal form of a particular arrangement. Relevant to the classification is the pricing, terms and conditions of the arrangement under which the interest is


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issued. In order to determine what constitutes the relevant debt interest or equity interest as a matter of economic substance, Division 974 provides, in certain circumstances, for the aggregation of legally separate contracts.

3.17 In order to be a debt interest, a scheme must satisfy the debt test. The test is applied from the perspective of the issuer at the time when the arrangement came into existence. The key requirement of the debt test is that the issuer must have an effectively non-contingent obligation to provide a financial benefit that is substantially more likely than not to have a value that is equal to or greater than the value received from the holder. Financial benefits mean anything of economic value, including the asset being financed. An obligation is non-contingent if it is not contingent on any event, condition or situation other than the ability or willingness of that entity or connected entity to meet the obligation.

3.18 In order to be an equity interest, a scheme must satisfy the equity test, which is satisfied if the scheme is an interest in a company that is of a kind listed in the Division, unless it constitutes a debt interest. Broadly, those listed are:

a share in a company;

an interest that provides a right to a return from a company and either the right itself or the amount of the return is contingent on economic performance of, or at the discretion of the company; and

an interest that may or will convert into such an interest or share.

3.19 Division 974 contains a tie breaker rule so that if an interest meets both the tests for a debt interest and an equity interest, it will be classified as a debt interest.

3.20 The debt/equity rules apply only to financing arrangements (and shares in companies). For this purpose, a financing arrangement is defined to be a scheme entered into or undertaken to raise finance for the entity, or a connected entity, or to fund another financing arrangement.

3.21 While Division 974 applies to a very broad range of debt instruments, equity instruments and hybrid instruments, it does not apply to all arrangements that raise finance. The definition of financing arrangement is used to limit the scope of the Division. That is, there are a number of arrangements that raise finance that are specifically excluded from the definition of financing arrangements in Division 974. For instance, certain lease or bailment arrangements, including, but not limited to, those that are subject to specific tax provisions. It should be noted that the exception to Division 974 for certain leases would not apply if the lessee has an obligation or a right


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to acquire the leased asset. To the extent that an excluded arrangement raises finance, the scope of Division 974 is arguably form based.14

3.22 Further, while the debt test can apply to an interest in any entity, the equity test only applies to equity interests in companies. That is, the equity test will not apply to equity interests in trusts or partnerships, unless they are treated as companies for tax purposes, such as corporate limited partnerships.15

3.23 Deductibility of a return on a debt interest is not dependent on the return being interest. For example, returns in the form of dividends paid on a debt interest may be deductible, subject to certain limits. Generally speaking, a return paid on a debt interest will be deductible if it meets the general deduction criteria in section 8-1 of the ITAA 1997. That is, expenses incurred in deriving assessable income are deductible when incurred, provided that they are not of a private, domestic or capital nature.

TOFA TAX TIMING RULES

3.24 The tax timing rules in Division 230 of the ITAA 1997 are intended to provide increased efficiency, reduced compliance costs and greater alignment between tax and commercial recognition of gains and losses made on financial arrangements.

3.25 The TOFA tax timing rules promote an economic substance over form approach, recognising that the law has not always kept pace with financial innovation.

The current income tax law has often placed greater emphasis on the form rather than the substance of financial arrangements. This has resulted in inconsistencies in the tax treatment of transactions with similar economic substance which has impeded commercial decision-making, created difficulties in addressing financial innovation, and facilitated tax deferral and tax arbitrage.16

3.26 Accordingly, the TOFA tax timing rules have regard to gains and losses rather than rely on form-based amounts such as interest. Division 230 defines financial arrangement and sets out the tax timing methods under which gains and losses from financial arrangements are brought to account for tax purposes. These methods accruals, realisation, fair value, retranslation, hedging and financial reports determine the tax timing treatment of all financial arrangements covered by Division 230.

14 Although, if the arrangement is covered by another specific financing provision, that provision may more appropriately deal with it in a substance based way.

15 Note however that there is a wider application of equity interest for the purposes of Division 230 (TOFA tax timing rules) and Division 820 (Thin capitalisation rules) of the ITAA 1997.

16 Explanatory memorandum to the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2008 para 1.7.


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3.27 Division 230 also effectively removes the capital/revenue distinction for most financial arrangements by treating the gains and losses on revenue account. One important exception is the elective hedging method which matches the characteristic of the gains and losses on the hedging financial arrangement to the revenue/capital characteristic of the underlying hedged item.

3.28 Broadly, a Division 230 financial arrangement is an arrangement where the rights and obligations under the arrangement are cash settlable. In addition, Division 230 applies to equity interests (under the elective fair value or financial report methods), foreign currency, non-equity shares in companies and certain commodities and offsetting commodity contracts. While these arrangements may not be cash settlable financial arrangements, they share some of the key characteristics of such arrangements, such as their money-like nature or the way they are dealt with by relevant parties to the arrangement.

3.29 Whether the rights and obligations are cash settlable needs to be tested on an ongoing basis. An important consequence of this is that a contract for the provision of goods or services can give rise to a financial arrangement. For example, under a deferred payment arrangement, parties to the arrangement may start to have a Division 230 financial arrangement upon the delivery of the non-monetary goods or property or upon the performance of services. This would occur when, at the time of delivery or performance, the only rights and/or obligations that remain under the deferred payment arrangement are to receive or pay the monetary consideration for the goods or property delivered or the service performed.

3.30 However, for compliance and administrative reasons, Division 230 does not apply to gains and losses arising from certain short term deferred payment arrangements. For instance, if the delay in payment is no more than 12 months after the receipt or delivery of the relevant non money or money equivalent goods, property or services.

3.31 If a deferred payment arrangement is within the scope of Division 230, it provides that, for the purposes of the income tax law, the cost of the arrangement is the market value of the relevant goods, property or services when they are delivered or performed.

3.32 For example, ABC Co enters into an agreement to sell a CGT asset (which is not a financial arrangement) to XYZ Co for $100, and agrees to allow XYZ Co 18 months from delivery of the asset to pay. Upon the delivery date, the market value of the CGT asset is $80. ABC Co has a financial arrangement consisting of its cash settlable right to receive $100, and the cost of the financial arrangement is taken to be $80. The difference between this cost ($80) and the proceeds ABC Co receives from the financial arrangement ($100), a $20 gain, is taken into account under Division 230.

3.33 TOFA tax timing rules have wide application but some arrangements fall outside the scope of the regime even though, in terms of economic substance, they would or


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could otherwise be financial arrangements. For example, Division 230 does not apply to certain lease or licence arrangements and interests in partnerships and trusts.

3.34 Further, Division 230 does not apply to certain gains or losses made from financial arrangements for compliance costs or other policy reasons. Such arrangements include arrangements held by small business, where they have an aggregated turnover of less than $100 million, financial assets of less than $100 million and assets of less than $300 million, and arrangements held by individuals.

3.35 Generally, Division 230 treats gains and losses made from financial arrangements as assessable income and deductions, respectively, over the life of the financial arrangement (consistent with financial accounting treatment). Gains and losses and financial benefits are to be taken into account only once in working out a taxpayers assessable income.

3.36 In broad terms, gains and losses from financial arrangements can be made in one of two ways: having a financial arrangement or disposing of a financial arrangement. In determining what constitutes a disposal, Division 230 takes into account the de-recognition criteria adopted by financial accounting standards. For example, if a financial arrangement is an asset, a legal transfer is effectively taken not to have occurred unless its effect is to transfer to another entity substantially all the risk and rewards of ownership of the asset.

3.37 Specific rules for bad debt deductions are included in the accruals and realisation methods which are the default tax timing methods under Division 230. A bad debt for the purposes of Division 230 is intended to be the same concept as that encompassed in section 25-35 of the ITAA 1997. Broadly, a bad debt deduction is allowed where the taxpayer has written off, as a bad debt, a right to receive a financial benefit or part of a financial benefit. The amount of the deduction is limited to the amount of the gain that has already been assessed under Division 230, to the extent that the gain was reasonably attributable to the financial benefit which was written off as bad. That is, unless the taxpayer has lent money or bought a right to receive a financial benefit in the course of their business of lending money. In this situation, the allowable deduction includes the principal investment provided.

HIRE PURCHASE AND FINANCE LEASE

3.38 The taxation of leases and hire purchase arrangements is based on an amalgam of legal form and economic substance based rules. In an attempt to better recognise the economic substance of certain arrangements the Taxation Laws Amendment (No. 1) Act 2001 introduced new rules that re-characterised hire purchase and certain finance lease arrangements as a notional sale and loan. The rules apply if the hirer has a right or obligation to acquire the asset and the amounts payable for the use and acquisition of the asset exceed the price of the asset. The excess amount is treated as the finance


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charge. The provisions (Division 240 of ITAA 1997) only apply to hire purchase agreements that relate to goods.

3.39 If the notional sale and loan rules apply, periodic payments are divided into principal and finance charge components. The finance charge component will be assessable to the lessor and may be deductible to the hirer/lessee. Normally the hirer/lessee and not the lessor will be treated as the owner/holder of the goods for Division 240 purposes.

3.40 These effects displace the tax consequences that would otherwise arise from the arrangement. For example, the actual payments to the notional seller are not included in assessable income and the notional buyer cannot deduct the actual payments to the notional seller. Under a finance lease a taxpayer lessor might be the legal owner of an asset and derive assessable income through rental of the asset. However, the taxpayer has transferred some or all of the risks and benefits associated with ownership of the asset to the entity that was the 'real' or 'end' user of the asset for a consideration that reflects the investment in the asset and a finance charge.

3.41 The consideration for the notional sale is either the actual cost or the arms length value. Where the property is trading stock, the normal consequences of disposing of, or acquiring, trading stock follow. In particular, the notional buyer can usually deduct the purchase price. If the property is not trading stock, the notional sellers assessable income will include any profit made on the sale and the notional buyer may be able to deduct amounts for the expenditure under Division 40 (capital allowances). The effect of the notional loan is that the notional sellers assessable income will include notional interest over the period of the loan and the notional buyer may be able to deduct notional interest payments.

3.42 Certain luxury car leases (other than short term hire arrangements and hire purchase agreements) are also treated as sale and loan transactions (Division 242 of the ITAA 1997).

3.43 Similarly, the Tax Laws Amendment (2007 Measures No. 5) Act 2007 amended the income tax law to modify the taxation treatment of finance leases and similar arrangements between taxpayers and tax preferred end users (such as tax-exempt entities and non-residents) for the financing and provision of infrastructure and other assets. The scope of this division (Division 250 of ITAA 1997) is limited to tax preferred end-users.

3.44 If Division 250 of the ITAA 1997 applies to a finance lease or service concession arrangement, then capital allowance deductions will be denied and the arrangement for the use of the asset will be treated as a deemed loan that is taxed as a financial arrangement on a compounding accruals basis.


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3.45 Division 250 will apply to a taxpayer if, broadly:

a tax preferred end user directly or indirectly uses, or effectively controls the use of, an asset; and

the taxpayer does not have the predominant economic interest in the asset.

3.46 A tax preferred end user will include a government body whose income was exempt from tax or a non-resident that used the asset outside Australia for the purpose of producing income that was exempt from Australian tax. Certain relatively short-term, lower value arrangements (including arrangements applying to small business entities) are specifically excluded from the scope of Division 250.

3.47 Consideration received for lease assignments is subject to a special assessment provision (Division 45 of the ITAA 1997).

3.48 The limited recourse debt rules in Division 243 of the ITAA 1997 were introduced to prevent taxpayers from obtaining deductions greater than the total amounts paid. For instance, where assets are financed under hire purchase or by limited recourse debt arrangements, the total cost may not be expended if the principal amounts remain unpaid at the termination of these agreements. Capital allowances are based on the initial cost of an asset or specified capital expenditure but do not take into account any non-payment under related financing transactions.

3.49 A general principle of the income tax law is that, in order to claim deductions for expenditure relating to ownership of an asset (such as capital allowances), the owner must show that the expenditure has been incurred and the asset is used for the purpose of producing assessable income or in carrying on a business for that purpose.

3.50 Leases, including finance leases that are not subject to specific statutory provisions, are subject to the ordinary income and deduction rules. The lessor is assessable on the rental income from the leased asset and is entitled to deductions for any related asset funding costs and capital allowances. The lessee may be entitled to deductions for rental expenditure if the asset is used for income producing purposes.

NON-RESIDENT WITHHOLDING TAX

3.51 Non-residents may be liable to Australian tax on Australian source income. Dividends and interest paid to non-residents are generally subject to a final withholding tax.

3.52 Dividend withholding tax is generally imposed at a flat rate of 30 per cent but, for dividends paid to residents of countries with which Australia has a tax treaty, the rate is generally limited to 15 per cent. Fully franked dividends, and unfranked dividends that are declared to be conduit foreign income, are not subject to


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withholding tax. Special withholding tax rules apply to distributions made by managed investment trusts to foreign residents. Dividends paid in respect of non-equity shares (shares that are not equity interests under Division 974 of the ITAA 1997) are treated as interest and subject to interest withholding tax (IWT).

3.53 IWT is payable on Australian source interest derived by a non-resident unless an exemption applies.17 Interest withholding tax is imposed at a flat rate of 10 per cent on the gross amount of the interest paid. Interest is generally regarded as an amount paid as compensation to a lender for not having the use of its capital. For withholding tax purposes, it includes amounts which:

are in the nature of interest;

can reasonably be regarded as having been converted into a form that is in substitution of interest; or

are dividends in respect of non-equity shares.

3.54 The interest withholding tax provisions extend to hire purchase and similar arrangements involving Australian entities purchasing plant and equipment from non residents. The provisions apply to the notional interest component of such arrangements (the excess of total payments made under the arrangements over and above the cost price of the goods).

3.55 There are a number of exemptions from interest withholding tax. For instance, subsection 128F(2) of the ITAA 1936 exempts from withholding tax the interest paid in respect of certain publicly offered debentures or debt interests. One of the conditions of the exemption is that the interest is paid by a company. A company includes all bodies or associations corporate or unincorporated, but does not include partnerships (except corporate limited partnerships subject to corporate tax) or non-entity joint ventures.

3.56 Section 128FA provides a further interest withholding tax exemption to publicly offered unit trust debentures or debt interests.

3.57 Section 128GB of the ITAA 1936 exempts from withholding tax the interest paid by an offshore banking unit in respect of its offshore borrowings.

3.58 Broadly, these exemptions reflect a policy of encouraging flows of capital from abroad. The exemptions aim to reduce borrowing costs for Australian business and government so that they do not face a restrictively higher cost of capital, or constrained

17 Interest paid on publicly offered debentures or specified debt interests issued by companies and public or widely held unit trusts are eligible for exemption from interest withholding tax. Interest paid on debentures and debt interests issued in Australia by the Commonwealth, States or Territories are also eligible for this exemption. In each case, the public offer test must be satisfied.


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access to capital, as a result of the withholding tax burden being shifted to them from the non-resident. The exemptions are also intended to integrate the domestic and offshore debt markets, enhancing Australia's development as a centre for financial services.

3.59 Limitations to the availability of the exemptions recognise that some forms of capital raising have the potential to reduce the integrity of Australia's tax system. So for example, the exemptions are targeted at financial instruments expected to fulfil an arm's length capital raising function in circumstances where shifting of the tax burden to the Australian borrower is most likely to occur. The 'public offer test' confirms the policy intent of restricting the exemption to structured capital raisings for business activities while excluding related party transactions and individually negotiated loans.

3.60 In recognition of the evolving nature of financial markets and innovation in financial instruments, a regulation-making power was included in sections 128F and 128FA of the ITAA 1936 to enable the prescription of other financial instruments as eligible for exemption. The Explanatory Memorandum to the Tax Laws Amendment (2007 Measures No.3) Act 2007 stated that:

It is anticipated that this power will only be used to prescribe financial instruments that are close substitutes for, and perform a similar role to, debentures. Consideration would also be given to the extent to which there is a detrimental impact on access to capital by Australian borrowers.

INTERACTION BETWEEN CGT RULES AND FINANCE TAXATION & SECURITIES LENDING ARRANGEMENTS

3.61 The application of the CGT provisions to an arrangement will typically depend on the legal form of the arrangement, for example the transfer of legal ownership of an asset. If CGT applies, the legal form of the arrangement will also generally determine the way in which the CGT provisions are to be applied. Net capital gains made in accordance with the CGT provisions are a type of statutory income. The CGT provisions apply in conjunction with the ordinary income tax provisions. Generally, a CGT gain is reduced if another income tax provision applies to the amount. A capital gain or loss is generally disregarded if it is part of a financial arrangement to which Division 230 or Division 250 of the ITAA 1997 applies.18

3.62 An example of a CGT event being disregarded so as to give effect to the economic substance of a financial product can be found in the securities lending provisions of the tax law. Securities lending arrangements comprises a legal sale together with an agreement to buy back the securities (or replacement securities)

18 For taxpayers subject to Division 230 the gain on disposal of a financial arrangement is usually on revenue account.


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within a certain period of time. The sale of the securities will give rise to a CGT event, but any capital gain or capital loss from the disposal of a borrowed security is specifically disregarded.

3.63 However, within the scope of the securities lending provisions the tax law recognises that the legal sale and purchase back of the relevant securities are, in substance, the borrowing of the money collateralised by the securities or, in substance, the borrowing of securities for a fee. Accordingly, the legal sale and the purchase back are disregarded for tax purposes.

GST

3.64 GST is a multi-stage value added tax. A key feature of the GST is that it provides business to business relief so that it is ultimately the final consumer that bears the cost of the GST.

3.65 Within the conventional finance sector, products that arguably are economically equivalent to each other may be treated differently for GST purposes if the nature and structure of the product are different. For instance, the economic substance of acquiring an asset under a finance lease may be equivalent to taking out a loan and buying the asset. However, economic equivalence in this case does not convert to similar treatment for GST purposes. Taxpayers can choose which arrangement they want and bear the GST consequences of that arrangement.

3.66 One reason for different GST treatment is that some types of consumption do not lend themselves to taxation under Australias invoice credit GST system. For instance, supplies that are classed as financial supplies including loans, derivatives, share trading and life insurance are input taxed.

3.67 This means that the supply is not taxable however the supplier cannot claim input tax credits for the GST component of the things it acquires for the purpose of providing that supply. Making these supplies input taxed overcomes difficulties in identifying the value-added margin on individual transactions, because input taxation does not require the service to be value added, but it may give rise to other distortions.19

3.68 The underlying policy is to input tax financial supplies only in cases where the consideration cannot be readily identified on a transaction by transaction basis. Given

19 The Australias Future Tax System Report (2009) found that the input taxation of financial supplies under the GST is inefficient, reduces competition and harms Australias position as a regional services centre. Financial services should be taxed in an equivalent way to other forms of consumption. That is, the consumption of financial services by Australian households should be fully taxed and financial services used by businesses should be treated like any other business input.


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this, it is not necessary that some arrangements such as hire purchase transactions, where the interest charge is separately identified and disclosed by the supplier, be input taxed. Following a recent review of financial supplies, the Government announced that the GST law will be amended to make the supply of hire purchase fully taxable. The change will mean that the GST treatment will not depend on the characterisation of the credit component.

3.69 For there to be a financial supply there must be a provision, acquisition or disposal of an interest, for consideration, in specified items. An interest means any form of property and includes a:

debt or right to credit.

mortgage over land or premises.

right under a contract of insurance or guarantee.

right to receive a payment under a derivative.

right to future property.

3.70 Generally, under Australias GST regime, supplies such as general insurance, leases including finance leases, hire-purchase, professional advice or broking services are treated as taxable. In addition, the provision of commercial property and new residential premises are taxable supplies whereas the provision of other residential premises is input taxed.

STATE AND TERRITORY TAXES

Victoria 3.71 Stamp duty typically applies to any purchase and declaration of trust of real property and chattels passing with the property. Duty is also payable on the purchase of motor cars. In Islamic financing transactions, there can be several transfers/declaration of trust of property as part of the financing arrangement.

3.72 In 2004, Victoria removed double stamp duty charges on property purchases by providing an exemption to dutiable transactions, generally on the second dutiable transaction in the arrangement. Other changes include recognising the principle of profit sharing and providing an equitable outcome in arrangements that avoid using certain terms which are not permitted, such as interest.20

20 Victorian Government fact sheet Islamic Finance, Melbourne, Victoria, Australia April 2010.


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3.73 The policy intent of the changes is to ensure equity so that taxpayers who enter into these arrangements are treated on an equal footing with those who enter into conventional mortgages. The changes provide for an exemption from duty if the creation or cessation of the financing leads to more than one dutiable transaction.

3.74 Victoria has also moved to allow an exemption where there is a refinancing with another Financier if it gives rise to a dutiable transaction. Transfer duty would otherwise have been payable on the steps required to give effect to the refinancing.

3.75 Also, there is no specific exemption for the financing of the purchase of motor cars.

New South Wales 3.76 Stamp duty typically applies to any purchase or declaration of trust of land and goods as well as goodwill, intellectual property and shares in an unlisted company and units in an unlisted unit trust scheme. Landholder duty may also be payable in connection with Islamic financing if shares or units are purchased. Duty is also payable on the purchase of motor cars.

3.77 Stamp duty on unlisted marketable securities, mortgages (in the limited circumstances in which it still applies), and on non-real property transfers will be abolished in New South Wales from 1 July 2012.

3.78 New South Wales does not have any special exemptions for Islamic financing transactions.

Queensland 3.79 Stamp duty typically applies to any purchase or declaration of trust of real property and chattels as well as goodwill, intellectual property and miscellaneous assets. Land rich duty may also be payable in connection with Islamic financing if shares or units are purchased. Duty is also payable on the purchase of motor cars.

3.80 Queensland does not have any special exemptions for Islamic financing transactions.

South Australia 3.81 Stamp duty typically applies to any purchase or declaration of trust of real property and chattels as well as goodwill, intellectual property and shares in an unlisted company and units in an unlisted unit trust scheme. Landrich duty may also be payable in connection with Islamic financing if shares or units are purchased. Duty is also payable on the purchase of motor cars.


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3.82 South Australia does not have any special exemptions for Islamic financing transactions.

Western Australia 3.83 Stamp duty typically applies to any purchase or declaration of trust of real property and chattels as well as goodwill, intellectual property and miscellaneous assets. Landholder duty may also be payable in connection with Islamic financing if shares or units are purchased. Duty is also payable on the purchase of motor cars.

3.84 Western Australia does not have any special exemptions for Islamic financing transactions.

Tasmania 3.85 Stamp duty typically applies to any purchase and declaration of trust of real property and chattels passing with the property. Landrich duty may also be payable in connection with Islamic financing if shares or units are purchased. Duty is also payable on the purchase of motor cars.

3.86 Tasmania does not have any special exemptions for Islamic financing transactions.

Northern Territory 3.87 Stamp duty typically applies to any purchase or declaration of trust of real property and chattels as well as goodwill, intellectual property and miscellaneous assets. Landholder duty may also be payable in connection with Islamic financing if shares or units are purchased. Duty is also payable on the purchase of motor cars.

3.88 Northern Territory does not have any special exemptions for Islamic financing transactions.

Australian Capital Territory 3.89 Stamp duty typically applies to any purchase and declaration of trust of real property and chattels passing with the property. Landholder duty may also be payable in connection with Islamic financing if shares or units are purchased. Duty is also payable on the purchase of motor cars.

3.90 Australian Capital Territory does not have any special exemptions for Islamic financing transactions.


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OBSERVATIONS ON THE CURRENT FINANCE TAXATION LANDSCAPE

3.91 As indicated above, there are various approaches to the treatment of financial products under current taxation laws. Some provisions take a legal form based approach, others an economic substance based approach, and some evidence a mix of these approaches. Even those that apply an economic substance based treatment often have a scope that is, to some extent at least, based on legal form. One approach might be more appropriate than another in a particular context. For example, it may be important to give greater weight to form for transaction based taxes that are of a high volume nature and rely on one party to collect or withhold the tax.

3.92 The economic substance based frameworks in the current income tax law such as the tax timing rules, hire-purchase and the debt equity rules are designed to better reflect the commercial understanding of the relevant arrangements and to improve tax neutrality in financial decision making. This review is to consider to what extent the current frameworks, either in their current form or perhaps with some modification, provide a way to appropriately recognise Islamic financial products for income tax purposes.

CHAPTER 4: ISSUES RAISED BY AUSTRALIAS CURRENT APPROACH TO FINANCE TAXATION

4.1 The purpose of this Chapter is to expose any issues that may be impediments to the development of Islamic finance. Each case study is consistent with the principles of Islamic finance and examines the application of the existing tax frameworks to enable a comparison with the tax treatment of the conventional equivalent product.

4.2 It is important to keep in mind that if the Board concludes that amendments to the tax law are required, the Board will consider whether adjustments can be made to existing tax frameworks rather than the development of specific provisions directed solely at Islamic finance products. For this reason this Chapter is aimed at examining those frameworks and identifying the limitations of Australias current finance taxation law in delivering on the principles outlined in the terms of reference rather than analysing Islamic finance arrangements and products in isolation.

CASE STUDY ONE: COST PLUS PROFIT SALE21

4.3 The purchase of residential property in Australia is typically financed by a mortgage arrangement. A mortgage over real property is a security for the lender. Under a conventional mortgage the property is purchased by the borrower using money borrowed from the lender. The property is transferred to the borrower and the borrower has to repay the loan amount plus interest as per the repayment schedule. The lender has a security over the property which means that if the borrower defaults, the lender can enforce a sale of the property to recover the money owed.

4.4 The economic substance of an Islamic mortgage product using cost plus profit sale is equivalent to a conventional mortgage. However, the form of the arrangement is different. In contrast to a conventional mortgage, the Financier will purchase the property and then sell it at cost plus a profit to the Client who will repay the cost plus profit on a deferred payment basis.

21 Known as Murabahah: refers to the sale and purchase transaction of an asset whereby the cost and profit margin (mark-up) are made known and agreed by all parties involved.

Chapter 4: Issues raised by Australias current approach to finance taxation

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Case Study One: Cost plus profit sale (of a rental property)

Step 1: A Client agrees to purchase a house from a vendor. The Client approaches a resident Financier to finance the purchase. A purchase instruction with promise to purchase is completed by the Client which is a request that the Financier purchase the asset specified and an undertaking to purchase that asset from the Financier.

Step 2: If the Financier approves the financing, an Asset Purchase Agreement will be executed where the Financier purchases the asset (house) from the vendor on a cash basis for a purchase price of $360,000. The Financier appoints the Client as its agent to purchase the asset. The asset is transferred to the Financier at this time.

Step 3: Asset Sale Offer and Acceptance notices will be executed, in which the Financier will offer to sell the asset to the Client on deferred terms at the purchase price ($360,000) plus a profit component ($384,341). The Financier will typically consider the prevailing mortgage interest rates for a similar credit risk. The Client will complete the Acceptance notice. The sale is executed and title is transferred to the Client with security granted to the Financier.

Example of Asset Offer Notice

Description of asset: residential property

Cost price: $360,000

Settlement date: 1 September 2010

Profit: $384,341 (8.4 per cent per annum)

Deferred payment price: $744,341

Deferred payment date: 30 August 2030 (20 Years)

Step 4: The Client will pay the sale price of $744,341 on an amortising monthly instalment basis over 20 years at $3,101.42 per month. The schedule for payments will typically look the same as a conventional loan agreement, with the cost and profit components clearly set out.

4.5 The Board is of the view that the economic substance of the arrangement described in Case Study One is the equivalent of a conventional fixed interest loan backed by a mortgage (mortgage). That is, the principal equivalent is the cost price of $360,000 and the interest equivalent is the profit component of $384,341.

3. Financier sells asset

2. Immediate payment to supplier

4. Deferred payment of cost plus profit

1. Financier acquires asset

Vendor Financier Client


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4.6 Therefore, considering the application of existing tax frameworks to a conventional mortgage, in principle, the following tax treatment should apply to Case Study One.

If the property is an investment property and is used to generate assessable income the profit component should be deductible for the Client at the time that it is actually paid. The sale of the property would ordinarily be direct to the Client and the Client would pay any stamp duty, and the Vendor any GST on the transaction. The Client would incur stamp duty on any mortgage if the property is located in New South Wales. The cost price of the property should be the first element of the Clients cost base for CGT purposes. As deductible expenditure, the profit component should not form part of the cost base.

For the Financier the profit component should be treated as a gain that it makes from a financial arrangement. Accordingly the tax timing rules in TOFA would determine the amount of the gain to be brought to account in each income year. The acquisition and disposal of the property by the Financier would not occur in the provision of a conventional mortgage and accordingly it should not have any practical tax consequences.

4.7 Because of the form of the arrangement the tax treatment of Case Study One under current tax frameworks will be different to a conventional mortgage used for investment purposes.

4.8 Duty would be payable on the initial purchase by the Financier and the sale to the Client. For example, the consequence of the purchase and sale by the Financier to the Client is that even though the Financier pays the duty on the acquisition this cost will be passed on to the Client (perhaps added to the cost of the property or an additional fee). In addition, the Client will incur a further duty charge when the property is transferred to them by the Financier. The result is that duty is paid twice on what is, in substance, one purchase.

4.9 Case Study One may also lead to tax uncertainty for the Client in relation to whether they can deduct the profit component, or whether this amount will form part of the cost base of the property for CGT purposes. The profit component may not be deductible under the general deduction provision (section 8-1 of the ITAA 1997) if it is paid to acquire a capital asset.22 Section 25-85 of the ITAA 1997 facilitates a deduction in relation to a return on a debt interest by providing that deductibility is not prevented merely because the return secures a permanent or enduring benefit. However, it is arguable that the Client does not purchase the property in the course of any existing income producing activity and therefore the profit component included in the purchase price is not incurred in the course of gaining or producing assessable income (the expenditure is incurred at a point to soon).

22 Colonial Mutual Life Assurance Society Ltd v FCT (1953) 89 CLR 428.


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4.10 If the profit component is not deductible it will form part of the cost base of the property for CGT purposes and will only be taken into account in the future if the Client sells the property. This treatment fails to recognise that, in substance, the profit component is arguably equivalent to interest, is paid over the life of the arrangement and is not a capital cost of acquiring the property.

4.11 For the Financier, the TOFA tax timing rules are likely to apply which means the profit component is likely to be included in assessable income as a gain from a financial arrangement using the accruals method. This is the same tax treatment as for interest on conventional mortgages. If the Financier is a non-resident then the return may fall within the extended definition of interest for IWT purposes, depending on the terms of the specific agreement. That is, if it represents the increased price payable because of a delayed payment then it may be sufficiently similar to an amount paid as compensation to a lender for being kept out of the use of its money. This would be equivalent to a conventional mortgage provided by a non-resident.

4.12 The disposal of the house by the Financier to the Client would typically trigger CGT event A1. The capital gain may be reduced by the amounts included in the assessable income of the Financier under other provisions. The time of the event is when the contract for disposal is entered into. This is at the beginning of the arrangement. A capital gain arises if the proceeds exceed the cost base. The amount the Financier is entitled to receive would constitute proceeds from the CGT event, even if not yet received. However, if the Financier is subject to the TOFA tax timing rules the rules may operate so that the capital proceeds will be the market value of the property at the time it is provided. This will occur when the Financier starts to have a financial arrangement as consideration for the disposal of the property to the Client.

4.13 For GST purposes, if the house is new, the supply of new residential premises by the Vendor to the Financier is a taxable supply. However the supply of the premises by the Financier to the Client is an input taxed supply because the property is no longer new. If the house is an existing residential premises both supplies will be input taxed.

4.14 The GST consequences for a conventional mortgage and for the product described in Case Study One are largely equivalent, however, there may be a GST cost to the Financier associated with lost entitlement to reduced input tax credits in respect of acquisitions that relate to making input taxed supplies.

4.15 Generally there is no entitlement to input tax credit on acquisitions that relate to making input taxed supplies. However the GST law allows a reduced input tax credit entitlement in respect of certain acquisitions that relate to making input taxed financial supplies. For example, outsourced loan management services might be a reduced credit acquisition if the Financier provided a loan. No reduced credit acquisition would arise if the Financier acquired similar services but the transaction was in the form of a supply of residential premises rather than a financial supply.


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4.16 Accordingly, there will not be GST neutrality between a conventional Financier lending funds to a client to purchase a house (and making a financial supply) and another Financier that structures its dealings in a way that seeks to deliver similar outcomes but does not give rise to financial supplies. This is because:

if the terms of the sale from Financier to the Client do not incorporate a financial supply in addition to the supply of the house, then to the extent that similar acquisitions are required to put the deferred payment arrangement in place, the GST law will apply adversely to the Financier as against a conventional Financier. This is because no acquisition made by the Financier would be a reduced credit acquisition and therefore the Financier will not be entitled to any reduced input tax credits; and

it would be expected that the Financier would embed the GST elements of prices it has paid to acquire reduced credit acquisitions into the profit component in its offer price to the Client. A conventional Financier could claim 75 per cent of full input tax credit on such acquisitions and so would be expected to on-charge that much less to its clients.

4.17 In the context of existing tax frameworks and the tax treatment of a conventional mortgage, the tax treatment or impediments to the development of the product described in Case Study One seem to be:

double stamp duty (except in Victoria), but no land tax issue;

for GST purposes, lost entitlement to reduced input tax credits for the Financier;

uncertainty in relation to whether the profit falls within the definition of interest for the purposes of IWT; and

tax uncertainty for the Client in relation to whether the profit component:

can be deducted under section 8-1 of the ITAA 1997, or

is a cost of acquiring the property and therefore included in the cost base for CGT purposes.


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Questions: Case Study One

Q1.1 Do you agree with the issues identified in the above summary? Do you have any further comments in relation to the issues identified?

Q1.2 What are the tax impediments in addition to those summarised to the development of the home financing product described in Case Study One?

Q1.3 How could tax neutrality be achieved in relation to:

Income tax (including IWT);

Stamp duty; and

GST?

Q1.4 How would your answer be different if the property were a commercial property?

Q1.5 Please consider the application of stamp duty in the context of Islamic mortgage funds.

Q1.6 Have the Victorian amendments to the Duty Act worked effectively to provide a level playing field?

CASE STUDY TWO: INTERBANK FINANCE23

4.18 Australia is a net capital importer which means Australian Financiers need access to offshore capital to meet the lending requirements of their Clients, Australian businesses and other consumers. Banks can access offshore finance through the use of a debt instrument. The instrument typically is structured in a way that meets the requirements for an IWT exemption such as the exemption for certain publicly offered debentures.

4.19 Islamic finance institutions can access offshore capital through the use of a reverse cost plus profit sale, as described in Case Study Two. The economic substance of the arrangement is equivalent to conventional debt instruments but the form of the arrangement is different. Instead of the bank offering the debt instrument directly to Financiers, an Investment agent will facilitate the financing arrangement (using the capital contributed by the Financiers) by making the initial commodity purchase and

23 Known as tawarruq (cash finance sale): A variation of murabahah, under a tawarruq contract a person buys a commodity or some goods on credit with an understanding of paying back the price either in instalments or in full in the future, and the commodity is immediately sold to third party to obtain cash.


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selling it to the bank at a profit on deferred payment terms (similar to Case Study One). The bank then sells the commodity to access the cash and repays the cost plus profit to the Investment agent (Financiers) in accordance with the agreement.

Case Study Two: Interbank finance

Step 1: Non-resident Syndicated Financiers enter into investment agency agreement with an Investment Agent (Australian resident bank or Financier).

Step 2: Resident Investment Agent purchases commodity for example metals at purchase price from commodity Supplier on spot settlement and spot payment basis.

Step 3: Investment Agent as agent for the Non-Resident Syndicated Financiers sells commodity to Client (another Resident bank or Financier) at Sale Price (Purchase Price plus Profit) on spot settlement but deferred payment basis (Client owns commodi

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Taxation of Islamic Finance Discussion Paper